‘Crack-addict stoozing’ or ‘stoozing on steriods’ is one way to describe the Carry Trade. It’s important at this point to realise that the carry trade knows no boundaries, and it seeps through literally millions of investments, from food to mortgages. What is the ‘Carry Trade’? Simply put it’s kind of like institutional stoozing (see previous post on stoozing). When you stooz you get a credit line of 0% or close to it (normally in the form of a credit card) you borrow all you can on it and put the money on deposit, when the 0% credit runs out you repay the loan and keep the deposit interest you earned. The same thing is being done with Japan, only in the billions, even trillions.
Institutions borrow money from the Bank of Japan at extremely low interest rates (at one point it was 0%!), typically below 1% and then they often leverage this money (borrow using it as collateral) up and invest in anything that might grow, in fact this practice had a lot to do with the worldwide credit crisis we are presently in, one that Governments are hoping to regulate harshly so that we don’t see a re-run of it ever again.
The issue now is that a world of ultra-intensive regulation will not work nor will it be adhered to by banks because they will simply re-locate specific branches in other jurisdictions and they will use every loophole available to manipulate the market to their favour, the best legal and tax teams money can buy will be enlisted to ensure this. That is why we have seen
Paul Volcker was the Fed Chairman (1979-1987) during some of the hardest years the US economy has faced, in his speech to the Economic Club of New York he spoke about the need for tough love from the Fed which is quite the opposite of what we are seeing today. He believes that what we are seeing today is the culmination of at least five serious break downs of systemic significance in the last twenty five years, roughly one every five years. Finance has accounted recently for 35-40% of corporate profits, this is far beyond normal relationships.
This new system has not really brought about equitable benefits to the wider economy, economic growth and productivity in the last 25 years is roughly comparable to the 1950’s & 60’s, but in the past it was shared, now the wealth is concentrated in derivatives, institutional investments, and complex vehicles that defy comprehension even for many at board level of the firms controlling them. So now the mutual trust of many markets is unravelling. The bright new system, for all of its rich rewards and all of its talent has failed the test of the market place.
Lending to non-banking financial institutions by the Fed will imply that they will come to the rescue of banks in the future if there is turmoil, now we see questionable securities being transferred from bank to the Fed, the Fed’s underlying tenet is to lend freely at high rates against good collateral, and to do that to the point of no return.
So when will we see the hammer drop? Certainly, from Volckers speech one would assume that we are merely putting off the inevitable? Perhaps this is true, and perhaps it is the carry trade that will eventually force this eventuality. What we have seen is a wealth effect from the huge amounts of money being made but as quickly as it has been made it can disappear, that is evidenced on an almost daily basis by looking at financial losses and write-downs being made by institutions worldwide. CitiBank made a write down that was bigger than AIB! Imagine a write off that is larger than one of this countries largest banks?
It is largely the availability of cheap credit that Volcker feels was at the heart of the issue, the credit bubble came about because people moved away from saving and shifted into debt. Financial crises normally arise after a self re-enforcing process of market exuberance marked by too much lending and too much borrowing, that trend was visible since the dotcom downturn. Regulation will now have to re-align itself and likely it will be directed into unknown territory, certainly a more transparent and central role is required but at what point does it become inhibiting to progress?
So where does the stooz come into play? It comes from the largest money factory in the world and we know it under the name ‘Japan’. Due to ongoing exceptionally low interest rates every big lender is borrowing from them and then moving the money into other markets to purchase fixed income bonds or other investments. Japans base rate is currently 0.5%, it was left unchanged after yesterdays meeting. The Yen is almost ‘free money’ because you can borrow in it and then turn it into any other currency and you will get more than the 0.5% being charged for it, keeping all the difference is where the money-market ‘stooz’ comes into play, all you need to do is place the money anywhere that you get more than the 1% or less that Japan has been charging for its money.
This carry trade typically finds a home where ever the highest returns are to be found, recently that was in securitized debt, the idea being that the fixed income would pay the fixed interest and the trader keeps the difference, perhaps it is part of the reason that Asian REITS (real estate investment trusts) have crashed so much as well? The carry trade creates bubbles where ever it goes, initially the benefit can be spread to the wider economy but eventually its just pure usury and for that reason it makes me feel that perhaps there are some Regulatory insights in the area of Islamic finance which forbids making money on money alone.
The Bank of Japan became the secret stooz provider because the Japanese economy was so bad that they reduced the interest rate to 0% but rather than fixing Japan it lead to a booming ‘carry trade’. Carry trade is so simple to understand it takes virtually no smarts to comprehend it, you borrow at 0% and place on deposit or into any investment that pays more than that (and the associated costs). If you borrowed €1,000,000,000 at 0% (the underlying Yen value being whatever it was) and lodged it at 4% you would make €40m for nothing, assuming the Yen didn’t move much in comparison to your currency you did really well, if the Yen weakened even just a little then you did VERY VERY well!
Now there is talk of the money getting ‘homesick’ and that could mean the unwinding of something that makes the sub-prime mess look like a nice picnic on a sunny day. Currency markets are amongst the biggest in the world, and the money in them moves in billions and trillions, not just mere (mortal) millions. Its 40 times bigger than the entire New York Stock Exchange.
The strengthening Yen means that the borrowers of that currency are getting hit on repayment capacity due to the underlying currency obligation. In plain English, although the interest rate is low the Yen itself is getting stronger (it went up over 25% in the first quarter alone!) so you need more Dollars/Roubles/Dinars etc. to pay back the ongoing interest and this is hurting the stooz that previously existed, so some people are cashing in their stooz accounts and hence the ‘homesick money’ is heading back to Japan.
Is this coincidence? Not really, because the Bank of Japan and the Yen are (to a degree) the hidden financiers of Wall St. it’s not surprise that the Yen rallies every time the Dow gets hurt. Now we are seeing the compression of Yen loans due to the currency getting stronger and the markets weakening, so borrowers have to repay the loans or go bust. Its self perpetuating as well because as the loans are repaid it has an inflationary effect on the currency and that makes it harder for the people left to repay these loans, so they all start to sell off assets in order to get the liquid cash to repay the loans, and this means that whatever the money was invested in (e.g.: CDO’s, SIV’s, REITS etc.) will see a rapid deflation in value, because there will be many sellers and not enough buyers so the price will have to drop to the point where it attracts buyers, in this example that price is in the region of ‘rock bottom’.
In every crash in the last 20 years the Yen rose in value when it happened, for that reason alone the rising Yen should be a noticeable symptom of the current recession, the issue though, is that some people say we are not ‘in a recession’, but because we work on historic figures its not always easy to tell when you are ‘there’, normally you have to look back and then make the mark of when the period started and finished.
One thing the market must do is dampen excessive leverage, and the carry trade unwinding, and the financial losses we are seeing may well achieve that without regulatory intervention. Paul Volcker is a genius, not a moniker he would likely readily accept, however, his views on tough love are starting to ring true to many in the financial industry, because if we listened to him then the bubble would not have existed to begin with, prevention is better than cure, rather than fixing a mess the likes of Volcker would have prevented the bubble from coming about.
Now Bernanke has two choices, raise USD rates and kill the stock market and hurt millions of Americans and give the markets there a serious kick to the face while they are already down. Secondly he can continue on the present path, lower rates, kill the dollar, save the market and home owners but let the carry trade unwind. Why will the carry trade unwind? Simply because the interest rates in USD and the rising Yen value against the Dollar will cause a rush to repay those Yen loans. And when those Yen loans are repaid, in effect the borrowers have to buy Yen in order to repay and that causes the uplift.
So it will mean an end to cheap money and stocks will take a beating. Europe won’t escape unscathed, and eventually the BRIC nations will catch the US/EU cold and feel the bite as well. There is an upside that we probably won’t see the insanity of extreme leverage again, and that will bring about a future of stability and sustainability, but before that day comes it’s gonna get ugly.